Credit risk is one of a number of risks that occurs when a loan is made.

Other risks are: market risk,

liquidity risk amongst others.

Default risk is often used interchangeably with credit risk.

The following definition will be used: Potential for the financial obligations of a contract not to be
fulfilled.

To identify credit risk properly, the following needs to be known:

The obligations of the borrower

The obligations of the lender

The payment dates for interest and principal

The maturity date

• Some observations for the definition of credit risk:

• The contract should protect the lender without discouraging the borrower.

• Credit risk is not static.

• The contract will include covenants that attempt to minimize the potential for the
risk to change such as use of assets or changing the capital structure

• The original way loans were considered.

• Most rely on the dual system of the experience of the lending officer and the checklist called
the 5 C’s

• Procedures tend to be the following:

• Receive the application from prospective borrower

• The loan is analysed according to the check list (5C’s)

• If the loan is granted, documentation is completed and funded.

• The loan is monitored.

• In this section of the lecture we will examine the more common way to analyse credit risk:

1. Expert systems

2. Risk premium analysis

3. Econometric methods
4. Hybrid systems